In 2020, Nikhil Arora (33) purchased a house worth Rs 75 lakh. For this, he had taken a home loan of Rs 60 lakh. However, a recent review of his outstanding dues revealed an unexpected setback. Despite diligently paying his equated monthly instalments (EMI) of approximately Rs 45,500 every month for nearly 35 months, Arora was shocked to find that the remaining loan amount still stood at around Rs 57 lakh. What's more, the loan tenure had increased from the initial 20 years to a staggering 50 years.
This culprit? Fluctuating and rising interest rates.
When Arora was initially granted the loan, the interest rate was 6.75 percent per annum. However, with subsequent increases in the repo rate, the lender revised the interest rate multiple times, and eventually it reached 9.45 percent per annum now. A careful examination of his repayment schedule revealed that in the first year, the principal was reduced by approximately Rs 1.45 lakh, followed by Rs 1.05 lakh in the second year, and a mere Rs 40,000 allocated towards principal repayment in the third year.
Arora's situation is not unique; many borrowers find themselves in a similar circumstance today. While this situation was primarily influenced by the significant surge in home loan interest rates, it could have been mitigated by limiting the loan amount and increasing the EMI amount when interest rates rise. This underscores the importance of making a higher down payment than what some popular thumb rules suggest. Let’s try to understand this a little better.
Mandatory down payment
A down payment in the context of a home loan refers to the initial upfront payment that a home buyer makes towards the purchase of a property from his or her own resources. The remaining amount is paid to the seller by the financing institution as a home loan. “The minimum down payment required for a home buyer availing a loan to buy a house from a bank or housing finance company (HFC) typically ranges from 10 percent to 20 percent of the property's value. This percentage may vary depending on the loan amount, lender's policies, buyer's creditworthiness, and certain other factors,” said Raoul Kapoor, Co-CEO, Andromeda Sales and Distribution Pvt Ltd.
The Reserve Bank of India (RBI) also keeps rolling out rules and guidelines to regulate the percentage of loans that can be sanctioned to home buyers.
According to Adhil Shetty, CEO, BankBazaar.com, “Typically, home loans are offered with a loan-to-value (LTV) ratio of up to 80 percent. This means that the lender will finance 80 percent of the property's value, excluding the registration and stamp duty charges, and the remaining 20 percent would be the down payment required from the homebuyer.”
However, the LTV ratio also varies based on the loan amount: smaller loan amounts tend to have higher LTV ratios, and visa-versa. “In case the loan amount is below Rs 30 lakh, then LTV can go up to 90 percent. On the other hand, if the loan amount is more than Rs 70 lakh, then the lenders may offer only up to 70 percent LTV,” said Shetty.
“Some HFCs may allow you to calculate the property value after including the registration and stamp duty charges. Some may even allow you to add the cost of furnishing the house to the overall property value. These can bring down the downpayment you need to make at the time of purchase. However, this would still mean out-of-pocket expenses to cover registration and furnishing expenses,” he added.
Ideal down payment
Although loans are available for up to 90 percent of the property’s value, it may not always be prudent to borrow the maximum amount available. In fact, experts recommend that home buyers contribute a significant portion of the purchase price from their own funds. There are several advantages to following this approach.
“Ideally, a home buyer should make a down payment of at least 20 percent of the property value. This is considered a standard benchmark and can lead to more favourable loan terms. However, if the financial situation allows, one may opt for paying up to 30-40 percent of the property value as a down payment,” said Kapoor.
Agrees Suresh Sadagopan, founder of financial planning firm Ladder7 Financial Advisories: he suggests a 30-40 percent or even more as a down payment, where feasible.
However, Shetty believes that there is no perfect down payment amount. “The lower your LTV, the better it is, as it will reduce your overall interest outflow. Ideally, your down payment should be the maximum out-of-pocket expense you can undertake after accounting for the LTV margin, registration, stamp duty, and other expenses such as furnishing,” said Shetty.
Benefit of higher down payment
While there are various benefits, the first is that it demonstrates to the lender that the buyer is financially committed to the purchase and is less likely to default on the loan. It also enhances the chances of getting better interest rates, as the risk for lenders decreases.
From the personal finance point of view, “it is always better to go for a higher down payment and limit the loan, as that would make servicing the loan easy,” said Sadagopan.
Before you proceed with taking a loan or determining the loan amount, there are several factors that should be considered. “The first is whether one can easily service the loan being taken. The other is whether it may be a good idea to borrow money instead of putting in one’s own money. If the investment return could be higher than the loan interest rate, then a bigger loan may make sense,” said Sadagopan.
Given that home loans typically have long tenors, such as 15 or 20 years, they necessitate a long-term commitment and thus warrant careful consideration.
Circumstances may evolve over the years, potentially making it challenging to meet the loan obligations. Therefore, it's crucial to contemplate various scenarios and devise strategies for handling unforeseen situations that may arise. “In families where the couple is working and they both take a loan, they need to understand that it limits the ability of the spouse to stop working to raise a family as that income may be necessary for several years to make loan servicing feasible,” said Sadagopan.
In addition to making a substantial down payment, it is wise to continue making partial repayments whenever surplus funds are available. Read more here.
Besides that, if there is an increase in the interest rate, consider whether you can comfortably manage a higher EMI rather than extending the loan tenure.